Comparison of Alternatives Chapter 4-4 Comparison of Alternatives Future Worth Analysis

Systematic Economic Analysis Technique 1. Identify the investment alternatives 2. Define the planning horizon 3. Specify the discount rate 4. Estimate the cash flows 5. Compare the alternatives 6. Perform supplementary analyses 7. Select the preferred investment

Future Worth Analysis Single Alternative

Future Worth Method converts all cash flows to a single sum equivalent at the end of the planning horizon using i = MARR used mostly for financial planning not a popular corporate DCF method (take all cash flows to “time n” and add them up!)

Example 6.1 A $500,000 investment in a surface mount placement machine is being considered. Over a 10-year planning horizon, it is estimated the SMP machine will produce net annual savings of $92,500. At the end of 10 years, it is estimated the SMP machine will have a $50,000 salvage value. Based on a 10% MARR and future worth analysis, should the investment be made? FW = -$500K(F|P 10%,10) + $92.5K(F|A 10%,10) + $50K = $227,341.40 =FV(10%,10,-92500,500000)+50000 = $227,340.55

Example 6.2 How does future worth change over the life of the investment? How does future worth change when the salvage value decreases geometrically and as a gradient series?

Example 6.3 A recent engineering graduate began investing at age 23, with a goal of achieving a net worth of $5 million by age 58. If the engineer obtains an annual return of 6.5% and makes a first investment of $5000, what gradient increase is required? G(A|G 6.5%,36) + $5000 = $5,000,000(A|F 6.5%,36) G = [$5,000,000(A|F 6.5%,36) - $5000]/(A|G 6.5%,36) (A|F 6.5%,36) = 0.065/[(1.065)36 – 1] = 0.0075133 (A|G 6.5%,36) = {(1.065)36 – [1 + 36(0.065)]}/{0.065[(1.065)36 – 1]} = 11.22339 G = [$5,000,000(0.0075133) - $5000]/11.22339 = $2901.66

Multiple Alternatives Future Worth Analysis Multiple Alternatives

Example 6.4 Recall the example involving two design alternatives (A & B) for a new ride (The Scream Machine) in a theme park. A costs $300,000, has revenue of $55,000/yr, and has a negligible salvage value at the end of the 10-year planning horizon; B costs $450,000, has revenue of $80,000/yr, and has a negligible salvage value. Based on a FW analysis and a 10% MARR, which is preferred? FWA(10%) = -$300,000(F|P 10%,10) + $55,000(F|A 10%,10) = $98,436.10 =FV(10%,10,-55000,300000) = $98,435.62 FWB(10%) = -$450,000(F|P 10%,10) + $80,000(F|A 10%,10) = $107,810.60 =FV(10%,10,-80000,450000) = $107,809.86 Analyze the impact on FW based on salvage values decreasing geometrically to 1¢ after 10 years; analyze the impact of changes in the MARR on the recommendation; and perform incremental analysis.

Example 6.4 Recall the example involving two design alternatives (A & B) for a new ride (The Scream Machine) in a theme park. A costs $300,000, has revenue of $55,000/yr, and has a negligible salvage value at the end of the 10-year planning horizon; B costs $450,000, has revenue of $80,000/yr, and has a negligible salvage value. Based on a FW analysis and a 10% MARR, which is preferred? FWA(10%) = -$300,000(F|P 10%,10) + $55,000(F|A 10%,10) = $98,436.10 =FV(10%,10,-55000,300000) = $98,435.62 FWB(10%) = -$450,000(F|P 10%,10) + $80,000(F|A 10%,10) = $107,810.60 =FV(10%,10,-80000,450000) = $107,809.86 Analyze the impact on FW based on salvage values decreasing geometrically to 1¢ after 10 years; and analyze the impact of changes in the MARR on the recommendation.

Example 6.6 Recall the example with two design alternatives for The Scream Machine: A costs $300,000, has revenue of $55,000/yr, and has a negligible salvage value at the end of the 10-year planning horizon; and B costs $450,000, has revenue of $80,000/yr, and has a negligible salvage value. Based on an incremental FW analysis and a 10% MARR, which is preferred? FWA(10%) = -$300,000(F|P 10%,10) + $55,000(F|A 10%,10) = $98,436.10 > $0 =FV(10%,10,-55000,300000) = $98,435.62 > $0 (A is better than “do nothing”) FWB-A(10%) = -$150,000(F|P 10%,10) + $25,000(F|A 10%,10) = $9374.50 > $0 =FV(10%,10,-25000,150000) = $9374.25 > $0 (B is better than A) Prefer B

Example 6.8 Perform an investment portfolio analysis for the investment involving two design alternatives for The Scream Machine. FWDN(10%) = $450,000(F|P 10%,10) = $1,167,183.00 =FV(10%,10,,-450000) = $1,167,184.11 FWB(10%) = $80,000(F|A 10%,10) = $1,274,993.60 =FV(10%,10,-80000) = $1,274,993.97 FWA(10%) = $55,000(F|A 10%,10) + $150,000(F|P 10%,10) = $1,265,619.10 =FV(10%,10,-55000)+FV(10%,10,,-150000) = $1,265,619.72

Compare investment alternatives over a common period of time More on Unequal Lives Principle #8 Compare investment alternatives over a common period of time

Example 6.9 If an investor’s MARR is 12%, which mutually exclusive investment alternative maximizes the investor’s future worth, given the parameters shown below? What planning horizon should be used? What assumptions are made regarding Alt. 1 for years 4, 5, and 6?

Example 6.9 (Continued) If we use a 6-year planning horizon and assume no cash flows will occur in years 4, 5, and 6 for Alt. 1, the future worths will be as follows: FW1(12%) = -$10,000(F|P 12%,6) + [$5000(F|A 12%,3) + $5000](F|P 12%,3) = $10,990.43 =FV(12%,6,-5000,10000)+FV(12%,3,5000,-5000) = $10,990.36 FW2(12%) = -$14,500(F|P 12%,6) + $5000(F|A 12%,6) = $11,955.56 =FV(12%,6,-5000,14500) = $11,955.52 FW3(12%) = -$20,000(F|P 12%,6) + $3000(A|G 12%,6)(F|A 12%,6) = $13,403.40 =FV(12%,6,-1000*NPV(12%,0,3,6,9,12,15)+20000) = $13,403.27

Example 6.9 (Continued) If we use a 6-year planning horizon and assume Alt. 1 repeats with identical cash flows for years 4, 5, and 6 for Alt. 1, the cash flow profiles will be as follows:

Example 6.9 (Continued) Under the assumption that Alt. 1 is repeated with identical cash flows for years 4, 5, and 6, the future worths will be as follows: FW1(12%) = -$10,000(F|P 12%,6) + $5000(F|A 12%,6) - $5000(F|P 12%,3) + $5000 =FV(12%,6,-5000,10000)+FV(12%,3,,5000)+5000 = $18,813.08 FW2(12%) = -$14,500(F|P 12%,6) + $5000(F|A 12%,6) =FV(12%,6,-5000,14500) = $11,955.52 FW3(12%) = -$20,000(F|P 12%,6) + $3000(A|G 12%,6)(F|A 12%,6) =FV(12%,6,-1000*NPV(12%,0,3,6,9,12,15)+20000) = $13,403.27 Is it reasonable to assume an investment alternative equivalent to Alt. 1 will be available in 3 years? If so, why was the MARR set equal to 12%?